Resolve the last problem assuming Work Station Inc has an abandonment option at the end of the first year under which it will recover $5 million of the initial investment in year 2. What is the value of the ability to abandon the project? How does your overall recommendation change?

Valuing Real OptionsReal Options usually –have definite costs early in projects –Create additional income along only one path–The chance of more income increases NPVAn option’s value is at least the increase in NPV less the option’s cost–But the real option may be worth more if it also reduces project risk (e.g. abandonment )

Valuing Real OptionsThe Risk Effect is Tricky – –Not all real options have a risk effect–To lower risk an option has to reduce a potential loss not make a success better–A case by case analysis is necessaryAn Approach Through Rate of Return–If lower risk is associated with a lower rate of return in NPV calculations, the result is higher NPV 36

Designing Real Options into ProjectsAbandonment option –Usually increase NPV and lower risk–Contract obligations can make abandonment toughExpansion options–Often require little or no early commitment –Should be planned in whenever possibleInvestment timing options–Permit delaying investment until more certain about surrounding issuesFlexibility options–Preserve ability to respond to changing business conditions37

Incorporating Risk Into Capital Budgeting–For NPV–k is used as the discount rateA higher k leads to lower NPV reducing the chance of project acceptance–For IRR–Compare IRR to kA higher k leads to a lower chance that IRR>k reducing probability of project acceptance38The cost of capital (k) plays a key role in both NPV and IRR.

Incorporating Risk Into Capital BudgetingRiskier Projects Should Be Less Acceptable–Using a higher, risk-adjusted rates for risky projects lowers their chance of acceptanceThe Starting Point for Risk-Adjusted Rates is the firm’s current risk level reflected in its cost of capital 39

Incorporating Risk Into Capital BudgetingRelating Interest Rates to Risk–Interest rates are comprised of a base rate plus a risk premium–Investors demand a higher risk premiums higher interest rates if they are to bear more risk–In capital budgeting the company is the investor 40

Incorporating Risk Into Capital BudgetingChoosing the Risk-Adjusted Rate for Various Projects–An arbitrary, subjective processThree categories of increasing risk–Replacements – low risk, use cost of capital –Expansion projects - slightly more risky than the current level –New ventures – generally involve a lot more risk 41

Estimating Risk-Adjusted Rates Using CAPMThe project as a diversification–If viewed as a collection of projects, a new venture diversifies the firm–A new venture also diversifies the stockholders’ investment portfolios42

Estimating the Risk-Adjusted Rate Through Beta

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- Spring '17
- Edwin Tolentino
- Net Present Value, Probability theory, probability density function